Score 0 of 1 pt 7 of 10 6 complete HW Score 475 475 of 10 P

Score: 0 of 1 pt 7 of 10 (6 complete) | HW Score: 475%, 4.75 of 10 P15-14 (similar to) Question Help Intergrative Comparison of loan terms Cumberland Funiture wishes to establish a prearranged borrowing agreement with a local commercial bank The bank\'s terms for a ine of crede are 2 70% over the prime rate, and each year the bomo ng must be reduced to zero for a day period For an equivalent revoing aedt agreement the rate s 1 6 % over prime with a cor mtrent fee of 0 % on the average unused balance with both loans, the required compensa ng balance is oqual to 10% of the amount borrowed Note untertan currently antans soon de sit at the b nk The e ates currently 8%. Both agreements have S 00 borrow ng i ts. The f m expects on average bo w S 00 00 during the year no matter which loan agreement it decides to use a. What is the effective annual rate under the ine of credit? b. What is the effective annuai rate under the revolving credit agreement? (Hint Compute the ratio of the dolars that the firm will pay in interest and commitment fees to the dolars that the firm wil effectively be able to use) c. If the 1rm does espect to borrow an average of halif the amount available, which arrangement would you recommend for the borrower? Explain why a. The emectve annual rate under te ine of aedt is% (Round to two decimal places.)

Solution

Part a

Effective annual interest rate: Interest / (Amount borrowed - Compensating Balance)

Here, interest = $ 4,000,000 x 10.70% = $ 4,28,000

Compensating Balance = Amount borrowed x Compensating rate

= $ 4,000,000 x 10% = $ 4,00,000

Therefore, effective annual interest rate = $ 428,000 / $ 3600000 = 0.1188 or 11.88%

Part b

Interest = $ 4,000,000 x 9.60% = $ 384,000

Commitment fees= Average unused balace x commitment fee rate

= $ 2,000,000 x 0.50% = $ 10,000

Compensating Balance = $400,000

Effective annual interest rate = (Interest + Commitement fees) / (Amount borrowed - Compensating Balance)

= $ 384,000 + $ 10,000 / $ 3600000 = 10.94%

Part C

I would recommend rvolving credti because of lower interest rate and commitment it brings.